Are ARMs making a comeback?

Adjustable-rate mortgages — which fell out of favor during the recession and recovery — are stirring consumer interest again in the local market.

The recent run-up in 30- and 15-year fixed loan rates have sparked more inquiries into adjustables, or ARMs, because these loans generally offer lower rates at first. That may translate to savings upfront.

But is an ARM right for you, given what happened in the previous housing boom and bust? Many consumers link such mortgages to the housing crash because sub-prime adjustable-rate mortgages were the culprit in many bankruptcies and foreclosures.

The exotic products that got homeowners into trouble were often sold with little or no income documentation. Also, some of these loans were structured so that borrowers were repaying only interest, or worse, paying less than required to cover the mortgage interest — termed a negative amortization schedule. That left borrowers paying interest on their interest payments.

Typical adjustable-rate mortgages originated today are far more conservative than the riskier products of the housing-bubble days. They’re also stringently underwritten, like their fixed-rate counterparts.

However, like all financial instruments, today’s ARMs carry risks. Their rates will change and can lead to shifts in monthly payments, depending on the way financial markets move.

“And someone who has been around the block before, has some financial assets and can withstand potential payment changes are the logical users of adjustables,” Lea added.

Then and now

One year before San Diego County’s housing market peaked, a record 85 percent of home-purchase loans were adjustables, show figures from real estate tracker DataQuick dating to 1988.

At that time, mortgage companies routinely gave out loans to would-be homebuyers after little or no review of employment or ability to pay.

To make matters worse, many borrowers got deeply discounted teaser rates that eventually adjusted and made monthly payments unaffordable. Others took on interest-only loans that resulted in rising mortgage balances. As home prices fell, an increasing number of those borrowers found themselves underwater on their loans. Many defaulted and mass foreclosures followed.

“These were the extreme examples of adjustables,” said Lea, the real estate professor.

Fast-forward nine years. Those high-risk products of the housing run-up are largely gone. Adjustable-rate mortgages now make up 8 percent of the total purchase-loan market.

That slice of the market, dormant for nearly five years, may start to grow as more consumers are trying to find lower rates.

A 5-year hybrid adjustable-rate loan that tracks the Treasury index averaged 3.17 percent this week, show figures from mortgage giant Freddie Mac. That’s more than 1 percentage point lower than the average 30-year fixed rate, which has edged up in the past month.

Hybrids — which mix the features of an adjustable-rate loan and a fixed one — have become the loan of choice for clients who are certain they will be in a home for a shorter period of time and can sustain drastic payment changes, said Baxter Scruggs, loan officer at Kearny Mesa-based Guild Mortgage.

Hybrid mortgages offer a fixed rate for a certain period of time before it adjusts, typically moving up. For example, a 5/1 adjustable-rate hybrid would mean the rate is fixed for the first five years of the loan and then will adjust every year until the loan is paid off.

Unlike adjustables of the past, today’s ARMs require consumers to prove they can afford their mortgage payments. Applicants must provide an extensive list of paperwork, including pay stubs, tax records and credit reports.

What to know

Adjustable-rate mortgages have a lot of moving parts, so it’s important to understand how they work. Consumers should know or ask about:

• What the different loan types are. Consumers, for instance, can pick from a variety of hybrid adjustables, including 3/1s and 5/1s to 7/1s and 10/1s. The first digit denotes the duration of the fixed rate timeframe and the second digit denotes the how often the rate will adjust after the initial period.

• How long they intend on staying at the home they’re buying. For people planning on remaining in their homes for a short period a time, a longer-term fixed mortgage such as a 30-year may not make sense.

• Adjustable-rate mortgages are often used in the jumbo-loan market, where rates tend to be higher. An ARM can save consumers thousands of dollars.

• What goes into determining rates. They’re based on adding the margin, which come from lenders, and the index, which varies by mortgage provider. Companies can base their rates on indexes such as the Treasury rate and London Interbank Offered Rate, or Libor. Their historical performances are publicly available. Ask lenders which they use.

• When and how their loans will adjust. Mortgage documents should clearly state how long the rates will be fixed and when they’ll change. Paperwork also must disclose rate caps, which limit how high interest rates can adjust periodically and over the life of the loan.

• Whether current income will cover the potential maximum-payment amount, which must be disclosed by lenders. ARMs may offer savings in the beginning but any changes to the index can mean higher rates and, in turn, higher monthly payments.

The future of ARMs

It’s unlikely that riskier adjustable-rate products will make a comeback, in light of the federal government’s push for more mortgage regulation.

One future rule would prevent mortgage lenders from using lower introductory rates to qualify borrowers. Lenders would instead have to use a higher fully-indexed rate, which could mean less people would get adjustables.

Such changes, brought on by the Dodd-Frank Act, are expected to go into effect next year.

The result could be a mortgage market that offers fewer and simpler mortgage products. The plus: Consumers may be less likely to get into financial trouble. The downside: less consumer choice, Lea said.

For now, since adjustable rates are lower than fixed ones, some mortgage professionals like Susanne Livingston, co-owner of Residential Whole Mortgage in Carmel Valley, are recommending to certain clients to get the longest-term adjustable-rate possible with a product such as a 10/1. That way, consumers can lock in lower rates for a longer period of time.

“Adjustable rates can prove to be very useful when they’re understood and when consumers are educated,” Livingston said.